Index ETFs are another way investors can invest in the money market. It is like mutual funds but designed to track a benchmark. As investment tools, ETFs are considered safer than investing in stocks. But if you are a new investor, it could be dangerous to invest without the proper knowledge. This article discusses index ETFs, how it works, and advantages and disadvantages of investing in index ETFs.

What are Index ETFs?

Index ETFs are exchange-traded funds, track and replicate the returns of a benchmark index. These are pretty like index mutual funds, but whereas investors redeem mutual fund units at one price each day (calculated NAV value), ETFs are transacted throughout the day like ordinary stocks.

An ETF follows the stocks in the index and offers instant portfolio diversification like mutual funds. These funds may trade at a premium or discount against computed NAV, depending on the changes in underlier price. But these differences exist only for a short time and get rubbed out through arbitraging by institutional investors.

The price of ETFs moves with the intraday price of its underlying stocks. But there is another type of ETF called leveraged ETF or short ETF. It is like regular ETFs with a leveraged multiplier, which performs better when the underlying asset price falls.

Usually, the cost of investing in index ETFs is lower than investing in mutual funds. It is comparable to the cheapest no-load index mutual funds. However, investors will have to pay a standard commission for buying and selling units. But you can also select from the wide range of non-commission ETFs to avoid paying commissions on transactions. ETFs offer lower expense and brokerage commissions than trading stocks individually.

Benefits of Index ETFs

Instant diversification: Like an index traded product, index ETF offers instant portfolio diversification in a tax-efficient and cost-effective fashion. These products track the performance of the benchmark index and invest in stocks featured in it. Broad-based ETFs are less volatile than individual stocks, allowing investors to invest across sectors.

High liquidity: Index ETFs are preferred for their liquidity. Units of index ETF funds can be bought or sold in the exchange like ordinary stocks during trading sessions. Hence, traders can create trading strategies involving index ETFs, which mutual fund investors can’t.

Mutual funds unit values are calculated once daily at the end of the trading session. Hence, all units are bought and sold at a fixed daily price. Conversely, index ETF values change with the intraday price of the underlying stocks, meaning they trade slightly premium or discount than the fund’s NAV.

Safe investment: Index ETFs are safe investments if used correctly. Most ETFs are index funds that invest in the same equities in an index, which comprises the large-cap stocks from different sectors. When the overall market trend is bullish, the index ETFs follow suit. Over time, the index funds tend to gain value, and so will be the index ETF.

Low-cost investment: Since index ETFs follow a benchmark and invest in the same stocks in the index, the involvement of a mutual manager is nominal. It reduces the cost of managing the fund, making it cheaper than actively managed mutual funds.

Fund managers will buy or sell stocks to index ETFs only when the shares are added or removed from the index.

Key takeaways

  • Index ETFs are passive investment options.
  • It is a basket of securities that invest in the same stocks in the index it tracks. Index ETF tracks and mimics the index’s returns it follows and invests corpus in a predetermined proportion.
  • Index ETFs trade in the exchange like regular stocks as their price varies with the changes in the underlying asset prices.
  • Index ETFs offer low-cost investment options to investors.

Difference between index funds and index ETFs

Both index funds and index ETFs follow a market index, but there are subtle differences between the two.

One fundamental difference is ETFs are listed in an exchange and traded during the day like ordinary stocks. Investors can invest in them in real-time NAV. Index mutual funds are not available for trading. Instead, they sell like mutual funds on a fixed NAV.

Index ETFs and index funds offer a high level of transparency as they invest in the same stocks featured in the index. ETFs offer daily disclosure of portfolios, and one can trade them as regular stocks in the exchange. However, a transaction amount above Rs 30 lakh would require an AMC.

The endnote

ETFs are like mutual funds with some notable differences, and there are several advantages of investing in ETFs. But it is important to note that, like for any investment, index ETFs also carry risks which include deviating from the index it follows. It may vary as much by a percentage point at a given time. Hence, investors must include asset fees, liquidity, and tracking errors as common risks of investing in index ETFs.

Whether you should invest in index ETFs is a matter of personal choice based on one’s investment goals.

If you are looking for liquidity, then index ETFs can be traded intraday. Secondly, one must consider the impact cost and the difference between the NAV value and the ETF units’ price. Depending on your investable corpus, time horizon, and goals, you can select the best index ETF from the current vast options available to investors.